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What Will Happen to Real Estate Leases when Operating Leases are Gone?

Many people are concerned about what will happen to real estate leases when FASB and IASB abolish operating leases. They plan to unveil the proposed standards on treating leases this summer as part of the convergence project but no "finalized ruling" is expected for at least a year because it will need to get formal consensus from many players, such as the SEC, American Association of Investors, Congress, the Big Four, American Associate of Realtors, the international equivalents of these, etc.

If your accounting is a bit rusty, an Operating Lease is where you lease equipment or some asset for a shorter period than the actual (expected) life of the asset and then give the asset back while it still has some useful life in it. (Think leasing a car). Because an Operating Lease does not contain any of the provisions that would qualify it as a Capital Lease, the lease is not treated as a sale or purchase and hits the lessee's rental expense and the lessor's revenue. So it all stays on the P&L (assuming no prepayments are made).

Capital Leases, on the other hand, hit lessee's and lessor's balance sheets because the asset is treated as a sale. (I'm ignoring interest and depreciation here to emphasize my point).

Question: What will happen to real estate leases when Operating Leases go away and how will Oracle Financials address these changes?

Before I attempt to address these questions, here's a real-life example to expound on some of the issues:

Let's say a U.S. retailer leases a store in a mall for 15 years. Under U.S. GAAP, the lease is considered an operating or expense lease.

Will that same lease be considered a capital lease under IFRS? Real estate leases are supposedly going to be capitalized under IFRS.

If so, will everyone need to change all leases from operating to capital? Or, could we make some adjustments so we report the lease as an expense for operations reporting but capitalize it for SEC reporting?

Would all aspects of the lease be capitalized, or would some line items still be expensed? For example, many retail store leases are defined to include (1) the agreed-to rent amount; (2) a negotiated increase in base rent, e.g., maybe a 5% increase in Year 5; (3) a sales rent component whereby the retailer pays a variable additional amount based on the sales generated in the prior month; (4) parking lot maintenance fees. Would the entire lease be capitalized, or would some portions still be expensed?

To help answer these questions, I met up with our resident accounting expert and walking encyclopedia, Seamus Moran. Here's what he had to say:

Oracle is aware of the potential changes specific to reporting/capitalization of real estate leases; i.e., we are aware that FASB and IASB have identified real estate leases as one of the areas for standards convergence.

Oracle stays apprised of the on-going convergence through our domain expertise staff, our relationship with customers, our market awareness, and, of course, our relationships with the Big 4. This is part of our normal process with respect to regulatory compliance worldwide.

At this time, Oracle expects that the standards convergence committee will make a recommendation about reporting standards for real estate leases in about a year. Following typical procedures, we also expect that the recommendation will be up for review for a year, and customers will then need to start reporting to the new standard about a year after that. So that means we would expect the first customer to report under the new standard in maybe 3 years.

Typically, after the new standard is finalized and distributed, we find that our customers then begin to evaluate how they plan to meet the new standard. And through groups like the Customer Advisory Boards (CABs), our customers tell us what kind of product changes are needed in order to satisfy their new reporting requirements. Of course, Oracle is also working with the Big 4 and Accenture and other implementers in order to ascertain that these recommended changes will indeed meet new reporting standards.

So the best advice we can offer right now is, stay apprised of the standards convergence committee; know that Oracle is also staying abreast of developments; get involved with your CAB so your voice is heard; know that Oracle products continue to be GAAP compliant, and we will continue to maintain that as our standard.

But exactly what is that "standard"--we need to wait on the standards convergence committee.

In a nut shell, operating leases will become either capital leases or month to month rentals, but it is still too early, too political and too uncertain to call out at this point.